Endogenous State Prices, Liquidity, Default, and the Yield Curve

Raphael Espinoza (), Charles A. E. Goodhart and Dimitrios Tsomocos

OFRC Working Papers Series from Oxford Financial Research Centre

Abstract: We show, in an exchange economy with default, liquidity constraints and no aggregate uncertainty, that state prices in a complete markets general equilibrium are a function of the supply of liquidity by the Central Bank. Our model is derived along the lines of Dubey and Geanakoplos (1992). Two agents trade goods and nominal assets (Arrow-Debreu (AD) securities) to smooth consumption across periods and future states, in the presence of cashin-advance financing costs. We show that, with Von Neumann-Morgenstern logarithmic utility functions, the price of AD securities, are inversely related to liquidity. The upshot of our argument is that agents’ expectations computed using risk-neutral probabilities give more weight in the states with higher interest rates. This result cannot be found in a Lucas-type representative agent general equilibrium model where there is neither trade or money nor default. Hence, an upward yield curve can be supported in equilibrium, even though short-term interest rates are fairly stable. The risk-premium in the term structure is therefore a pure default risk premium.

Keywords: cash-in-advance constraints; risk-neutral probabilities; state prices; term structure of interest rate (search for similar items in EconPapers)
JEL-codes: E43 G12 (search for similar items in EconPapers)
Pages: 27
Date: 2007
New Economics Papers: this item is included in nep-cba, nep-cfn, nep-dge, nep-fmk, nep-mac and nep-upt
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Related works:
Working Paper: Endogenous state prices, liquidity, default, and the yield curve (2007)
Working Paper: Endogenous State Prices, Liquidity, Default, and the Yield Curve (2007)
Working Paper: Endogenous State Prices, Liquidity, Default, and the Yield Curve (2007)
Working Paper: Endogenous State Prices, Liquidity, Default, and the Yield Curve (2006)
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